The outlook for UK interest rates is markedly different from this time last year. The environment has become increasingly uncertain and while it seems we are now in a higher-for-longer rate environment, many experts believe we will see more rate cuts than are currently being priced in. This uncertainty presents both opportunities and challenges for the banking industry as we enter 2025.
The impact on challenger banks, that have grown rapidly in the recent era of rising interest rates, will be particularly interesting. While many challengers experienced a brief period in which interest rates were very low heading into and out of the pandemic, most have grown substantially during the raising interest rate period that followed and may come under pressure if rates fall dramatically in the near future.
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Impact on profitability and cost to income ratios
Interest rate cuts compress bank profitability and negatively impact cost-to-income ratios. Banks typically earn much of their income from the spread between interest on loans and deposit rates, so a lower interest rate environment will naturally narrow this spread, putting pressure on earnings.
The rising interest rates that we have seen since late 2021 have seen banks and shareholders develop higher profitability expectations. Given the current uncertainty in the interest rate environment, coupled with pressure to maintain these expectations and remain competitive against their peers, banks must be agile in their strategies to protect margins.
The budget’s hidden costs for banks
The ripple effects from Labour’s 2024 Autumn Budget have compounded the challenges banks are facing and will continue to do so throughout this year. The Chancellor’s 1.2% increase in National Insurance Contributions (NIC) will raise costs for UK businesses across the board. Banks, like all employers, will be forced to absorb this increase, leading to an immediate rise in operational expenses that will be reflected in their profit and loss statements.
But for challenger banks, major banking providers to UK SMEs, the challenges are more acute. On one hand, higher NIC costs may increase SMEs’ reliance on business loans as they grapple with added expenses while reevaluating their business strategies. But their financial vulnerability creates significant risks for banks longer-term, especially if its leads to more widespread defaults and collapses.
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By GlobalDataHowever, there is also an opportunity for banks to strengthen relationships with SME customers. Banks can help businesses navigate these turbulent times and foster long-term loyalty as trusted advisors offering tailored financial solutions.
Economic shifts set to disrupt lending and spending
Banks will inevitably face indirect impacts from the budget changes over the coming year, as they ripple through the economy, potentially affecting business lending demand and consumer spending patterns. Higher taxes on businesses and adjustments to individuals and families’ disposable incomes may slow economic growth, affecting demand for banking products such as credit and mortgages.
Demand has remained volatile post budget and banks must urgently recalibrate their strategies to account for shifting lending and spending patterns. This involves not only managing immediate profitability concerns but also anticipating long-term market changes.
Technological innovation and operational efficiency
To counteract these challenges, banks must embrace technological innovation and operational efficiency by streamlining key processes. To reduce inefficiencies and create more agile operational models, banks can consider optimising workflows through scaled Business Process Management (BPM) projects. They can also look at workforce transformation through Business Process Outsourcing (BPO) and offshoring of banking functions such as tech engineering.
Upgrading legacy systems, adopting cloud infrastructure, and refining digital services are equally critical for cutting costs and enhancing customer experiences.
The continued deployment of Robotic Process Automation (RPA) – infused with artificial intelligence – can automate repetitive tasks and improve decision-making. Long-term cost savings can also be found in moving data architecture to the cloud. Banks that fail to invest in their infrastructure risk falling behind in an increasingly challenging banking environment.
Reduction in branch numbers and a shift away from personal services
Additionally, as we progress through 2025, it is highly likely that we will see further reductions in branch numbers and a shift away from face-to-face or voice services. While these actions both serve as effective cost-saving measures, they must be carefully implemented in alignment with new Consumer Duty regulatory expectations to ensure that customer outcomes remain at the forefront and regulatory risks are minimised.
Pricing power through
Intelligent technologies like AI, process mining and automation offer challenger banks the opportunity to become markedly more efficient than their incumbent peers, enabling them to retain pricing power and protect revenue in this falling rate environment. To take advantage of these opportunities, challengers must ensure they have the necessary foundational capabilities across both data and engineering in place.
Graeme Carmichael is Executive Director at Capco
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